Description

Traditional theory suggests that more profitable banks should have lower risk-taking
 incentives. Then why did many profitable banks choose to invest in untested financial
 instruments before the crisis, realizing significant losses? We attempt to reconcile theory and
 evidence. In our setup, banks are endowed with a fixed core business. They take risk by
 levering up to engage in risky ‘side activities’(such as market-based investments) alongside
 the core business. A more profitable core business allows a bank to borrow more and take
 side risks on a larger scale, offsetting lower incentives to take risk of given size.
 Consequently, more profitable banks may have higher risk-taking incentives. The framework
 is consistent with cross-sectional patterns of bank risk-taking in the run up to the recent
 financial crisis.

More publications in this series: Working Papers

More publications by: Natalya Martynova ; Lev Ratnovski ; Razvan Vlahu